Reallocating and pricing illiquid capital: Two productive trees∗

We develop a two sector general equilibrium model with capital accumulation and convex adjustment costs. We use the model to study capital asset pricing and reallocation, as well as optimal consumption and investment decisions. With two sectors, the consumer balances diversification against the potential productivity and efficiency gains of investing more heavily in one sector. The general framework nests and extends standard equilibrium macro-asset pricing models. We show conditions under which aggregates are immune to the distribution of capital and in contrast, when the distribution becomes crucial for both sectoral and aggregate values. Applications of the framework highlight the importance of heterogeneity and capital liquidity the ability to reallocate capital for economic growth and asset pricing. Misallocated capital creates risk and reduces utility, but correcting it through capital reallocation reduces efficiency and growth. ∗We are grateful to Bob Hall (AEA discussant), Lu Zhang (AFA discussant), Bob Hodrick, and seminar participants at Stanford, 2009 AEA, and 2010 AFA for insightful comments, and to Jinqiang Yang for exceptional research assistance. †Kellogg School of Management, Northwestern University and NBER, Evanston, IL, USA. Email: [email protected]. ‡Columbia Business School and NBER, New York, NY, USA. Email: [email protected].